. 11
( 39)


Income Before Income Taxes 4,029 3,761 4,275

Provision for Income Taxes 1,367 1,218 1,770

Net Income $ 2,662 $ 2,543 $ 2,505

Net Income Per Common Share
Basic $ 1.51 $ 1.45 $ 1.41
Diluted $ 1.47 $ 1.42 $ 1.38

See accompanying notes to consolidated ¬nancial statements.
¬le=¬nancials.tex: RP
Section 9·1. Financial Statements.

Table 9.4. Consolidated Statement of Cash Flows PepsiCo, Inc. and Subsidiaries
Fiscal years ended December 29, 2001, December 30, 2000 and December 25, 1999.

in millions
52 Weeks 53 Weeks
Ending Ending
12/29/01 12/30/00
Cash Flows - Operating Activities
Net income $ 2,662 $ 2,543
Adjustments to reconcile net income to net cash provided by operating activities
Bottling equity income, net (160) (130)
Depreciation and amortization 1,082 1,093
Merger-related costs 356 “
Other impairment and restructuring charges 31 184
Cash payments for merger-related costs and restructuring charges (273) (38)
Deferred income taxes 162 33
Deferred compensation - ESOP 48 36
Other noncash charges and credits, net 209 303
Changes in operating working capital, excluding e¬ects of acquisitions and dispositions
Accounts and Notes Receivables 7 (52)
Inventories (75) (51)
Prepaid expenses and other current assets (6) (35)
Accounts payable and other current liabilities (236) 219
Income taxes payable 394 335
Net change in operating working capital 84 416
Net Cash Provided by Operating Activities 4,201 4,440

Cash Flows - Investing Activities
Capital spending (1,324) (1,352)
Acquisitions and investments in unconsolidated a¬liates (432) (98)
Sales of businesses “ 33
Sales of property, plant & equipment “ 57
Short-term investments. by original maturity
More than three months “ purchases (2,537) (4,950)
More than three months “ payments 2,078 4,585
Three months or less, net (41) (9)
Other, net (381) (262)
Net Cash Used for Investing Activities (2,637) (1,996)

(Continued on the following page.)
¬le=¬nancials.tex: LP
204 Chapter 9. Understanding Financial Statements.

(Continued from previous page.)

in millions
52 Weeks 53 Weeks
Ending Ending
12/29/01 12/30/00
Cash Flows - Financing Activities
Proceeds from issuances of long-term debt 324 130
Payments of long-term debt (573) (879)
Short-term borrowings, by original maturity
More than three months ” proceeds 788 198
More than three months ” payments (483) (155)
Three months or less, net ” payments (397) 1
Cash dividends paid (994) (949)
Share repurchases - common (1,716) (1,430)
Share repurchases - preferred (10) “
Quaker share repurchases (5) (254)
Proceeds from issuance of shares in connection with the Quaker merger 524 “
Proceeds from exercises of stock options 623 690
Net Cash Used for Financing Activities (1,919) (2,648)

E¬ect of Exchange Rate Changes on Cash and Cash Equivalents “ (4)
Net (Decrease)/Increase in Cash and Cash Equivalents (355) (208)
Cash and Cash Equivalents - Beginning of year 1,038 1,246
Cash and Cash Equivalents - End of period $ 683 $ 1,038

Supplemental Cash Flow Information
Interest Paid $ 159 $ 226
Income taxes paid $ 857 $ 876
Fair value of assets acquired $ 604 $ 80
Cash paid and debt issued (432) (98)
Liabilities Assumed $ 172 $ (18)
¬le=¬nancials.tex: RP
Section 9·1. Financial Statements.

9·1.B. PepsiCo™s 2001 Financials

Tables 9.1“9.4 contain the four main ¬nancial statements that PepsiCo reported in its 2001 The accounting view:
balance sheet, income
Annual Report. (The entire annual report is available at http://www.pepsico.com/investors/-
statement, and cash ¬‚ow
annual-reports/2001/pepsico_¬nancials2001.pdf.) statement.

The balance sheet in Table 9.1 provides a snapshot of the ¬rm™s assets and liabilities at a ¬xed
point in time. (It is a measure of “stock,” not of “¬‚ow” over an interval.)
Some assets (like cash and inventories) are fairly liquid and short-term, and are therefore
often called current assets. Other assets (like plants and brand reputation [an intangible
asset]) are much harder to convert into cold, hard cash if we were to sell the ¬rm, and
thus are itemized separately.
As in ¬nance, accounting forces the sum total of all assets to be owned by creditors and
shareholders. And, as with assets, some creditors are owed money short-term. These are
called current liabilities. Other debt is more long-term”and then there are obligations
to our “friend,” the IRS. The remainder”whatever assets are not accounted for by debt
owed to creditors”is called equity. Therefore,

Assets = Liabilities + Shareholders™ Equity .

If all assets and liabilities were properly valued, this accounting book value of sharehold-
ers™ equity would be the market value, too. However, accounting rules and di¬culties in
valuing assets and liabilities often render the book value of shareholders™ equity into more
of a “plug” number that serves to equalize assets and liabilities than into an intrinsically
meaningful ¬gure. You have been warned!

The owners™ equity statement (or “shareholders™ equity statement”) in Table 9.2 explains the
history of capital originally contributed to the ¬rm, and earnings that were retained (not
paid out). We will not use this statement.

The income statement in Table 9.3 reports the revenues and expenses of the company, re-
sulting in earnings (also called net income) over the year. (Thus, it reports a measure of
“¬‚ow,” not of “stock.”) Because it is hard to see the trees in so much forest, many ¬nancial
services produce an abbreviated form thereof, which you can ¬nd in Table 9.13 (Page 228).

In the above three statements, accountants seek to “smooth out” temporary hiccups”which
you will learn in a moment. It is only in the fourth statement that this is not attempted:

The cash ¬‚ow statement in Table 9.4 reports the sources and uses of cash over the year. (It
is a measure of “¬‚ow,” not of “stock.”) Again, an abbreviated version is in Table 9.14
(Page 229).

You should stare at these four statements for a while. But you can look as hard as you like, and
you will not ¬nd an item entitled “cash ¬‚ow for an NPV analysis.” And the cash ¬‚ows on the
cash ¬‚ow statement look nothing like the earnings, which is what the world seems to consider
important?! Somehow, we must try to understand what this ¬nancials mean so that we can
extract what we really need”a “cash ¬‚ow for our NPV analysis””from what we have: the four
¬nancial statements.
We will be spending a lot of time explaining the income statement and cash ¬‚ow statement, but Financial reports follow
accounting conventions.
the upshot will be that the cash ¬‚ow statement comes closest to what we want. However, to
understand why it is insu¬cient and where it comes from, we need to take a wider expedition
into the logic of accounting (and speci¬cally, of net income), which is di¬erent from the logic
of ¬nance (and speci¬cally, NPV cash ¬‚ows). So our next step is to learn how to read, interpret,
and transform ¬nancial statements into the cash ¬‚ows that an NPV analysis demands. You
also need this expedition to have a better understanding of earnings and ¬nancial statements
in general.
¬le=¬nancials.tex: LP
206 Chapter 9. Understanding Financial Statements.

9·1.C. Why Finance and Accounting Think Di¬erently

Both accountants and ¬nanciers are interested in ¬rm value. But the principal di¬erence be-
Earnings re¬‚ect future
costs and bene¬ts (in tween them is that the accountants try to approximate changes in the current value of the ¬rm,
some sense).
while the latter try to understand the exact timing of hard cash in¬‚ows and out¬‚ows over the
entire future. The former want to learn about earnings, the latter want to learn about cash
The main di¬erence between these two concepts of income and cash ¬‚ows are accruals: eco-
The difference between
income and cash ¬‚ows nomic transactions that have delayed cash implications. For example, if I owe your ¬rm $10,000
are accruals.
and have committed to paying you tomorrow, the accountant would record your current ¬rm
value to be $10,000 (perhaps time- and credit-risk adjusted). In contrast, the ¬nancier would
consider this to be a zero cash-¬‚ow”until tomorrow, when the payment actually occurs. The
contrast is that the accountant wants the ¬nancial statements to be a good representation of
the economic value of the ¬rm today (i.e., you already own the payment commitment), instead
of a representation of the exact timing of in¬‚ows and out¬‚ows. The ¬nancier needs the timing
of cash ¬‚ows for the NPV analysis instead.
Accruals can be classi¬ed into long-term accruals and short-term accruals. The primary long-
Financiers see actual
cash ¬‚ows: an expense term accrual is depreciation, which is the allocation of the cost of an asset over a period of
spike, followed by years
time. For example, when a ¬nancier purchases a maintenance-free machine, he sees a machine
of no expenses.
that costs a lot of cash today, and produces cash ¬‚ows in the future. If the machine needs to be
replaced every 20 years, then the ¬nancier sees a sharp spike in cash out¬‚ows every 20 years,
followed by no further expenditures (but hopefully many cash in¬‚ows).
The accountant, however, sees the machine as an asset that uses up a fraction of its value each
Accountants smooth
asset values over time. year. So, an accountant would try to determine an amount by which the machine deteriorates
in each year, and would only consider this prorated deterioration to be the annual out¬‚ow
(called an expense). The purchase of a $1 million machine would therefore not be an earnings
reduction of $1 million in the ¬rst year, followed by $0 in the remaining 19 years. Instead,
it would be an expense of $50,000 in each of 20 years. (This is a very common method of
depreciation and is called straight-line depreciation.)
To complicate matters further, accountants often use di¬erent standardized depreciation
Accountants use
impairment schedules. schedules over which particular assets are depreciated. These are called impairment rules,
and you already know the straight-line rule. Houses, for example, are commonly depreciated
straight-line over 30 years”often regardless of whether the house is constructed of wood or
brick. The predetermined value schedule is usually not accurate: For example, if investors
have recently developed a taste for old buildings, it could be that a building™s value has dou-
bled since its construction, even though the ¬nancial statements might record this building to
be worth nothing. (Even this is oversimpli¬ed. On occasion, accountants invoke procedures
that allow them to reduce the value of an asset midway through its accounting life”but more
often downward than upward.) Another common impairment rule is accelerated depreciation,
which is especially important in a tax context. (But we are straying too far.)
If the machine happens to continue working after 20 years, the ¬nancials which have just
There is some
inconsistency when the treated the machine as a $50,000 expense in Year 20 will now treat it as a $0 expense in
machine has been fully
Year 21. It remains worth $0 because it cannot depreciate any further”it has already been
fully depreciated. The ¬nancier sees no di¬erence between Year 20 and Year 21, just as long
as the machine continues to work.
Short-term accruals come in a variety of guises. To a ¬nancier, what matters is the timing of
For short-term accruals,
such as receivables, cash coming in and cash going out. A sale for credit is not cash until the company has collected
accounting logic relies
the cash. To the accountant, if the ¬rm sells $100 worth of goods on credit, the $100 is booked
on predicted cash ¬‚ows.
as revenue (which ¬‚ows immediately into net income), even though no money has yet arrived.
In the accounting view, the sale has been made. To re¬‚ect the delay in payment, accountants
increase the accounts receivables by $100. (Sometimes, ¬rms simultaneously establish an
allowance for estimated non-payments [bad debts].)
¬le=¬nancials.tex: RP
Section 9·1. Financial Statements.

Another short-term accrual is corporate income tax, which a ¬nancier considers to be an out- The logic of ¬nance
relies on actual cash
¬‚ow only when it has to be paid”at least not until (the corporate equivalent of) April 15 of
¬‚ows (or immediate
the following year. However, on the income statement, when a ¬rm in the 40% corporate tax values), only.
bracket makes $100 in pro¬ts, the income statement immediately subtracts the corporate in-
come tax of $40 (which will eventually have to be paid on the $100 in pro¬ts) and therefore
records net income of only $60. To re¬‚ect the fact that the full $100 cash is still around, $40
is recorded as tax payables.

In sum, for a ¬nancier, the machine costs a lot of cash today (so it is an immediate negative), the Both approaches have
relevant advantages and
accounts receivables are not yet cash in¬‚ows (so they are not yet positives), and the corporate
income tax is not yet a cash out¬‚ow (so it is not yet a negative). For an accountant, the machine
costs a prorated amount over a period of years, the accounts receivables are immediate pos-
itive earnings, and the corporate income tax is an immediate cost. There is de¬nite sense in
the approaches of both accounting and ¬nance: the accounting approach is better in giving a
snapshot impression of the ¬rm™s value; the ¬nance approach is better in measuring the timing
of the cash in¬‚ows and cash out¬‚ows for valuation purposes. Note that valuation leans much
more heavily on the assumption that all future cash ¬‚ows are fully considered. Today™s cash
¬‚ows alone would not usually make for a good snapshot of the ¬rm™s situation.
Solve Now!
Q 9.1 What are the main di¬erences between how accounting (net income) and ¬nance (NPV
cash ¬‚ows) see projects?

Q 9.2 Why is a ¬rm not just a ¬rm and accounting numbers not just “funny money”? That is,
what is the most important direct cash ¬‚ow in¬‚uence of accounting in most corporations?

Anecdote: Trashy Accounting at Waste Management
On December 14, 1998, Waste Management settled a class action lawsuit by shareholders for $220 million, then
the largest such settlement. (This will soon be dwarfed by the Enron, MCI WorldCom, and Arthur Andersen
debacles.) The suit alleged that WMX had overstated its income by $1.32 billion over an 8-year period. From
1994 through 1997, about 47% of the company™s reported income was ¬ctitious.
One of WMX™s dubious practices was that it had changed the accounting life of its waste containers from 12
years to 18 years. Therefore, each year, it subtracted less depreciation, which increased its reported earnings
by $1.7 billion. Of course, managers were handsomely rewarded for their superior earnings performance.
¬le=¬nancials.tex: LP
208 Chapter 9. Understanding Financial Statements.

9·2. The Bottom-Up Example ” Long-Term Accruals (Depreci-

Rather than starting o¬ trying to understand a creature as complex as the PepsiCo ¬nancials,
our method is to start with a simple ¬rm and construct hypothetical ¬nancials. We will then
use our knowledge to reverse the procedure. At the end of this chapter, we will do the same to
obtain NPV cash ¬‚ows from the PepsiCo ¬nancials.

9·2.A. Doing Accounting

We want to understand how depreciation drives a wedge between income and cash ¬‚ows. Start
The hypothetical project
to illustrate the with a simple project for which we know the cash ¬‚ows. Our ¬rm is basically just one machine,
accounting perspective
described in Table 9.5.
and the ¬nance

Table 9.5. A Hypothetical Project

Real Physical Life 6 Years
Capital Expenditure $75, year 1
Available Financing ” Executed
$75, year 2
Debt Capacity $50
Raw Output $70/year
Debt Interest Rate 10%/year
’ Input Costs (cash) $5/year
’ Selling Costs (cash) $5/year
= Net Output $60/year
Accounting Treatment
Overall Cost of Capital 12%/year
Project Life 3 Years
Corporate Tax Rate („) 40%/year

Note: This debt contract provides cash necessary in Year 1, and requires a ¬rst interest payment in year 2. Both
principal and interest are repaid in Year 6.

With $50 of debt at 10% interest, the ¬rm™s annual interest payments are $5. The machine (and
Elaborate on the
example. its tax depreciation schedule) is rather unusual: it has no maintenance costs; it requires capital
expenditures in the second year; it produces fully even in year 1; and divine intelligence tells
us that the machine will really last 6 years. But the IRS has decreed that depreciation of this
particular machine occurs over 3 years. So, $75 generates $25 in depreciation, three years in a
row, beginning in the year of the capital expenditure.

By assuming a lower interest rate of 10% on the debt than on the overall ¬rm™s cost of
capital of 12%, we are in effect assuming that ¬nancial markets are risk-averse”as they
truly are in the real world. Risk aversion is the subject of Part III.

Side Note: Sign Warning: You might think that a machine purchase of $75 would be recorded as a Capital
Expenditure of +$75. Alas, the accounting convention is to record this as a negative number, i.e., ’$75. You
are assumed to know that a negative expenditure is not a cash in¬‚ow, but a cash out¬‚ow. (But beware: capital
expenditures is recorded as a positive asset on the balance sheet.)
¬le=¬nancials.tex: RP
Section 9·2. The Bottom-Up Example ” Long-Term Accruals (Depreciation).

Table 9.6. Income Statement and Excerpt of Cash Flow Statement of Hypothetical Machine

Income Statement

Year 1 2 3 4 5 6

Sales (Revenues) $70 $70 $70 $70 $70 $70

“ Cost of Goods Sold (COGS) $5 $5 $5 $5 $5 $5

“ Selling, General & Administra- $5 $5 $5 $5 $5 $5
tive Expenses (SG&A)

= EBITDA $60 $60 $60 $60 $60 $60

“ Depreciation $25 $50 $50 $25 $0 $0

= EBIT (operating income) $35 $10 $10 $35 $60 $60

“ Interest Expense $0 $5 $5 $5 $5 $5

= EAIBT (or EBT) $35 $5 $5 $30 $55 $55

“ Corporate Income Tax (at 40%) $14 $2 $2 $12 $22 $22

= Net Income $21 $3 $3 $18 $33 $33

Excerpts From the Cash Flow Statement

Year 1 2 3 4 5 6

Capital Expenditures “$75 “$75 - - - -

Net Debt Issue +$50 - - - - “$50

Note: Though broken out in this sample income statement, parts of depreciation are often rolled into COGS or SG&A.
It is always fully broken out (and thus can be obtained from) the cash ¬‚ow statement.

The income statement for our project is shown in Table 9.6. In going down the left-most column Our project™s income
of any of these tables, you will notice that”as in ¬nance”accounting has its own jargon. COGS
abbreviates cost of goods sold; SG&A abbreviates selling, general & administrative expenses.
These are expenditures that have to be subtracted from sales (or revenues) to arrive at EBITDA:
earnings before interest and taxes, depreciation, and amortization. Next we subtract out
depreciation, which is a subject that deserves the long sidenote below and that we will return
to in a moment. Thus, we arrive at operating income, also called EBIT (earnings before interest
and taxes). Finally, we take out interest expense at a rate of 10% per year and corporate income
tax (which we can compute from the ¬rm™s tax rate of 40%) and arrive at plain earnings, also
called Net Income. Net income is often called the “bottom line,” because of where it appears.
Note the similarity of our project™s income statement to PepsiCo™s income statement from Ta- Compare our project to
ble 9.3. PepsiCo™s accountants prefer to put later years in columns to the left. In 2001, PepsiCo
had $26,935 million in sales. COGS and SG&A added up to $10, 754 + $11, 608 = $22, 362
million. Therefore, EBITDA was $26, 935 ’ $22, 362 = $4, 573 million. Amortization sub-
tracted $165 million. Other expenses amounted to $387 million, leaving us with EBIT of
$4, 573’$165’$356’$31 = $4, 021 million. In PepsiCo™s case, the combination of bottling eq-
uity income and transaction gains, interest expenses, and interest income was determined to be
its net interest income of $8 million. Uncle Sam demanded $1,367 million, leaving shareholders
with net income of $2,662.
¬le=¬nancials.tex: LP
210 Chapter 9. Understanding Financial Statements.

The depreciation that we need to add back for our NPV analysis is the $1,082 million on the
Side Note:
cash ¬‚ow statement, not the $165 million amortization that PepsiCo reports on its income statement. The
reason is that PepsiCo lumped most but not all depreciation into SG&A. Amortization omits depreciation of
non-physical plant assets. For clarity, I have added one line in Table 9.13, which breaks out the depreciation
from selling, general & administrative expenses. Edgarscan also reported net interest income/expense of $8,
which we therefore added to the table.
Non-Cash Items contain M&A costs of $356 from PepsiCo™s acquisition of Quaker Oats in August 2001. Note that
¬nancials are often restated, i.e., changed ex-post to re¬‚ect the acquisition of other businesses. This particular
procedure is called pooling. The idea is to report ¬nancials as if the two companies had always been conjoined.

Yes, PepsiCo has a few extra items, and changes some of the names around, but the broad
similarity should be apparent.
We have used almost all the information of our project. The two exceptions are the capital
There is one extra piece
of information that we expenditures and the net debt issue. They do not go onto the income statement. Instead, they
need to
are reported on the cash ¬‚ow statement (also in Table 9.6). In this case, capital expenditures are
$75 in Year 1 and $75 in Year 2, followed by $0 in all subsequent years. Net debt issuing is $50 in
Depreciation smoothes
capital expenditures.
Year 1, and the debt principal repayment of $50 occurs in Year 6. (For PepsiCo, in Table 9.3, you
can ¬nd the equivalent items as “capital spending” under Investing Activities and as proceeds
from issuances of long-term debt and payments of long-term debt under Financing Activities).
This is not to say that capital expenditures and debt play no role in the income statement”they
do, but not one-to-one. For example, capital expenditures reduce net income (in the income
statement) only slowly through depreciation. In the ¬rst year, the ¬rst $25 depreciation from
the $75 capital expenditures are accounted for; in the second year, the second $25 depreciation
from the ¬rst $75 capital expenditures are accounted for, plus the ¬rst $25 depreciation from
the second $75 capital expenditures are accounted for; and so on.

Side Note:

• Depreciation, depletion, and amortization are all “allocated expenses” and not actual cash out¬‚ows. The
di¬erence in names derives from the asset types to which they apply. Depreciation applies to Tangible
Assets, such as plants. Depletion applies to Natural Resources. Amortization applies to Intangible
Assets. Because depreciation, depletion, and amortization are really all the same thing, they are often just
lumped together under the catch-all phrase “depreciation,” a convention that we follow in this chapter.
• For tutorial purposes, our example commits an accounting error. Corporations have no consistent treat-
ment of depreciation on the income statement: some depreciation is typically rolled into cost of goods
sold (such as depreciation on manufacturing equipment; thus our machine™s depreciation would usually
be reported as part of cost of goods sold). Other depreciation may be rolled into selling, general & admin-
istrative expenses, and yet other depreciation may be broken out. Therefore, the only complete picture
of depreciation can be found on the cash ¬‚ow statement, where the sum-total of all forms of depreciation
is added back to net income.
• The rules for publicly reported ¬nancial statements are called GAAP (Generally Accepted Accounting
Principles) and change rarely. They are set by a number of policy makers, most prominently FASB (the
Financial Accounting Standards Board). For public reporting purposes, ¬rms are supposed to seek to
match true depreciation to reported depreciation.
• Although the IRS ¬nancial statements follow the same logic as the public ¬nancials, the statements
themselves are not the same. The IRS rules change often and are set by Congress. (Even states can have
their own rules.) The di¬erence is particularly pronounced when it comes to depreciation schedules.
Tax depreciation rules are set by the IRS, and they often apply strict mechanical schedules, regardless
of the true asset life. Consequently, there are many companies that report positive earnings to their
shareholders, and negative earnings to the IRS.
• In some countries, the ¬nancial and tax statements of public companies are identical. In the author™s
opinion, this is not a bad idea. In the United States, the public debate is how to get companies not
to be aggressive in reporting ¬nancial earnings (on which executive compensation is often based!). If
companies had to release their tax statements to the public, aggressive earnings manipulation would
become not only more di¬cult, but also more costly.
• To compute corporate income tax, our chapter should have used not the depreciation on the ¬rm™s
reported ¬nancial statements, but the depreciation on the ¬rm™s unreported tax statements. We commit
this error to facilitate the exposition.
• There is a small timing di¬erence between interest expense and when interest is actually paid. This is
usually about 1 month in timing. The value impact of this di¬erence is small, so we shall ignore it, and
just use interest expense as if it were immediately paid.

(These are very important account details”even if they are not particularly exciting.)
¬le=¬nancials.tex: RP
Section 9·2. The Bottom-Up Example ” Long-Term Accruals (Depreciation).

9·2.B. Doing Finance

Now, forget accounting for a moment, and instead let us value the machine from an under- The ¬nance perspective
focuses only on adding
lying ¬nance perspective. The ¬rm consists of three components: the machine itself, the tax
actual cash in¬‚ows and
obligation, and the loan. cash out¬‚ows. Note
difference between full
and levered ownership.
= NPV Machine ’ NPV Taxes ,
NPV Project
NPV Levered Ownership = NPV Machine ’ NPV Taxes + NPV Loan .

Full project ownership is equivalent to holding both the debt (including all liabilities) and equity,
and earning the cash ¬‚ows due to both creditors and shareholders. Levered equity ownership
adds the project “loan” to the package. As full project owner (debt plus equity), in the ¬rst
year, you must originally supply $50 more in capital than if you are just a levered equity owner,
but in subsequent years, the interest and principal payments are not negatives for you. (For
convenience, we ignore intra-year payment timing complications.)
We ¬rst work out the actual cash ¬‚ows of the ¬rst component, the machine itself. Without Let us look at the ¬rst
component of the
taxes and loan, the machine produces
¬rm”the machine™s
actual cash ¬‚ows,
$60 ’ $75 $60 ’ $75 $60
= + + without taxes and loan.
(1 + 12%) (1 + 12%) (1 + 12%)3
1 2

$60 $60 $60
+ + + = $119.93
(1 + 12%) (1 + 12%) (1 + 12%)6
4 5
NPVMachine,t=0 = + + +
1 + r0,1 1 + r0,2 1 + r0,3
+ + + .
1 + r0,4 1 + r0,5 1 + r0,6

Unfortunately, corporate income tax”the second component”is an actual cost which cannot The tax obligation is a
negative NPV project,
be ignored. Looking at Table 9.6, we see that Uncle Sam collects $14 in the ¬rst year, then $2
which must be calculated
twice, then $12, and ¬nally $22 twice. and then valued.

To value the future tax obligations, we need to know the appropriate discount factor.
Unfortunately, we need to delay this issue until Section a (Page 576). It is both conve-
nient and customary (if not exactly correct) to use the ¬rm™s overall cost of capital as
the discount rate for its tax obligations.

Assume that the stream of tax obligations has the same discount rate (12%) as that for the Value the tax liability,
and determine the
overall ¬rm. With this cost-of-capital assumption, the net present cost of the tax liability is
project NPV.
$14 $2 $2
NPVTax Liability = + +
(1 + 12%) (1 + 12%) (1 + 12%)3
1 2
$12 $22 $22
+ + + = $46.77 .
(1 + 12%) (1 + 12%) (1 + 12%)6
4 5

Put together,

NPV Project = NPV Machine ’ NPV Taxes = $119.93 ’ $46.77 = $73.16 .

Now consider the third component”the loan. Assume that we play not the “full project owner,” The loan usually is a
“Zero NPV” project,
but only the “residual levered equity owner,” so we do not extend the loan ourselves. Instead,
unless you can get an
a perfect capital market extends us a loan. We can assume that our company “got what it paid unusually great deal or
for,” a fair deal: the loan, which provides $50 and pays interest at a rate of 10%, should be zero unusually bad deal on
the loan.
NPV. (This saves us the e¬ort to compute the NPV of the loan!)

NPVLoan = $0 .
¬le=¬nancials.tex: LP
212 Chapter 9. Understanding Financial Statements.

Table 9.7. Cash Flows and Net Income Summary

1 2 3 4 5 6 Rate NPV

CF Machine w/o Tax “$15 “$15 +$60 +$60 +$60 +$60 12% $119.93

CF Uncle Sam “$14 “$2 “$2 “$12 “$22 “$22 12% “$46.77

CF Project “$29 “$17 +$58 +$48 +$38 +$38 12% $73.16

CF Loan +$50 “$5 “$5 “$5 “$5 “$55 10% $0.00
Residual CF:
Levered Ownership +$21 “$22 +$53 +$43 +$33 “$17 ? $73.16

For comparison,
Net Income $21 $3 $3 $18 $33 $33 n/a n/a

Note: The cost of capital (expected rate of return) is higher in this example for the machine than it is for the loan.
This will be explained when we discuss the role of risk-aversion, when the safer loan will command a lower cost of
capital than the riskier machine.

Be my guest, though, and make the e¬ort:

+$50 ’$5 ’$5 ’$5 ’$5 (’$50) + (’$5)
NPVLoan = + + + + + = $0 .
1 2 3 4 5 1.106
1.10 1.10 1.10 1.10 1.10
Therefore, the project NPV with the loan, i.e., levered equity ownership, is the same as the
project NPV without the loan. This makes sense: we are not generating or destroying any value
by walking over to the bank. Therefore

NPV Levered Ownership = NPV Machine ’ NPV Taxes + NPV Loan
= ’ + = $73.16 .
$119.93 $46.77 $0

Although the NPV remains the same, the cash ¬‚ows to levered equity ownership are di¬erent
from the cash ¬‚ows to the project. The cash ¬‚ows (and net income) are shown in Table 9.7.
Note how di¬erent the cash ¬‚ows and net income are. Net Income is highest in Years 5 and 6,
but levered cash ¬‚ow in Year 6 is negative. In contrast, in Year 3, the year with the highest
levered cash ¬‚ow, net income is lowest.

9·2.C. Translating Accounting into Finance

If you did not know about the details of this machine but saw only the ¬nancials, could you
Discounting the Net
Income does not give compute the correct ¬rm value by discounting the net income? Discounting net income with a
the true project NPV.
cost of capital of 12% would yield
$21 $3 $3
= + +
NPVvia Net Income (1 + 12%)1 (1 + 12%)2 (1 + 12%)3
$18 $33 $33
+ + + = $70.16 ,
(1 + 12%)4 (1 + 12%)5 (1 + 12%)6

which is de¬nitely not the correct answer of $73.16. Neither would it be correct to discount
the net income with a cost of capital of 10%,
$21 $3 $3
= + +
NPVvia Net Income (1 + 10%)1 (1 + 10%)2 (1 + 10%)3
$18 $33 $33
+ + + = $75.24 .
(1 + 10%)4 (1 + 10%)5 (1 + 10%)6
¬le=¬nancials.tex: RP
Section 9·2. The Bottom-Up Example ” Long-Term Accruals (Depreciation).

So, how do you reverse-engineer the correct cash ¬‚ows for the NPV analysis from the ¬nancials? Cash ¬‚ows can be
reverse engineered from
You ¬rst need to translate the ¬nancials back into the cash ¬‚ows that NPV analysis can use. You
the corporate ¬nancials.
just need to retrace our steps. You have both the income statement and cash ¬‚ow statement
at your disposal. First, to obtain the machine cash ¬‚ow, you can apply the formula

Year 1 Year 2
+$35 +$10
+ +$25 +$50
Depreciation (9.11)
+(’$75) +(’$75)
“+” (’)Capital Expenditures
= ’$15 ’$15
CF Project, Pre-Tax

to the numbers from Table 9.6. You add back the depreciation, because it was not an actual
cash out¬‚ow; and you subtract the capital expenditures, because it was an actual cash ¬‚ow. I
¬nd the formula most intuitive if I think of the depreciation + capital expenditures terms as
undoing the accountants™ smoothing of the cost of machines over multiple periods.

Important: The main operation to take care of long-term accruals in the con-
version from net income into cash ¬‚ows is to undo the smoothing”add back the
depreciation and take out the capital expense.

Side Note: The formula signs themselves seem ambiguous, because accountants use di¬erent sign conven-
tions in di¬erent spots. For example, because capital expenditures are usually quoted as negative terms on the
cash ¬‚ow statement, in order to subtract out capital expenditures, you just add the (negative) number. In the
formula below, you want to subtract corporate income tax, which appears on the income statement (Table 9.6)
as a positive. Therefore, you have to subtract the positive. Sigh... I try to clarify the meaning (and to warn you)
with the quotes around the +, and the cumbersome “ +′′ (’) in the formulas themselves.

Now you need to subtract corporate income taxes (and, again, look at the numbers themselves Finish the
to clarify the signs in your mind; income-tax is sometimes quoted as a negative, sometimes as
a positive). This gives you the after-tax project cash ¬‚ow,

Year 1 Year 2
+$35 +$10
+ +$25 +$50
+(’$75) +(’$75)
(’)Capital Expenditures
’ ’(+$14) ’(+$2)
(+)Corporate Income Tax
= ’$29 ’$17
CF Project, After-tax

Net Income already has corporate income tax subtracted out, but it also has interest expense
subtracted out. So, the same cash ¬‚ow results if you start with net income instead of EBIT, but
add back the interest expense,

Year 1 Year 2
+$21 +$3
Net Income
+ +$25 +$50
+(’$75) +(’$75)
(’)Capital Expenditures
+ +(+$5)
Interest Expense (add back to Net Income) $0
= ’$29 ’$17
CF Project, After-tax
¬le=¬nancials.tex: LP
214 Chapter 9. Understanding Financial Statements.

Investors (equity and debt together) must thus come up with $29 in the ¬rst year and $17 in the
Cash ¬‚ow to levered
equity holders. second year. What part of this is provided by creditors? In the ¬rst year, creditors provide $50;
in the second year, creditors get back $5. Therefore, levered equity actually receives a positive
net cash ¬‚ow of $21 in the ¬rst year, and a negative cash ¬‚ow of $22 in the second year.
Therefore, with the loan ¬nanced from the outside, you must add all loan in¬‚ows (principal
proceeds) and subtract all loan out¬‚ows (both principal and interest). Therefore, the cash ¬‚ow
for levered equity shareholders is

Year 1 Year 2
+$35 +$10
+ +$25 +$50
+(’$75) +(’$75)
(’)Capital Expenditures
’ ’(+$14) ’(+$2)
Corporate Income Tax (9.14)
= ’$29 ’$17
CF Project
+ +$50
Net Debt Issue $0
’ ’$5
Interest Expense $0
= +$21 ’$22
CF Levered Equity Ownership

Again, net income already has both corporate income tax and interest expense subtracted out,
so again the same result obtains if you instead use the formula

Year 1 Year 2
+$21 +$3
Net Income
+ +$25 +$50
+(’$75) +(’$75)
(’)Capital Expenditures
+ +$50
Net Debt Issue $0
= +$21 ’$22
CF Levered Equity Ownership

Although you could now repeat the calculation for PepsiCo, hold your horses”we will do so
only after we have covered other issues.
Solve Now!
Q 9.3 Show that the formulas 9.11“9.15 yield the cash ¬‚ows in Table 9.7

Q 9.4 Using the same cash ¬‚ows as in the NPV analysis in Table 9.7, how would the project NPV
change if you used a 10% cost of capital (instead of 12%) on the tax liability?

Q 9.5 Rework the example (income statement, cash ¬‚ow statement excerpts, cash ¬‚ows, and
NPV) with the following parameters.

Anecdote: Solid Financial Analysis
EBITDA was all the rage among consultants and Wall Street for many years, because it seems both closer to cash
¬‚ows than EBIT and more impervious to managerial earnings manipulation through accruals. Sadly, discounting
EBITDA can be worse than discounting EBIT if capital expenditures are not netted out”and they usually are not
netted out. (Forgetting about capital expenditures when depreciation is not netted out is equivalent to assuming
that product falls like manna from heaven. EBIT may spread capital expenditures over time periods in a strange
way, but at least it does not totally forget it!) Sometimes, a little bit of knowledge is more dangerous than no
In June 2003, a Bear Stearns analyst valued American Italian Pasta, a small N.Y.S.E.-listed pasta maker. Unfor-
tunately, Herb Greenberg from TheStreet.com discovered that he forgot to subtract capital expenditures. This
mistake had increased the value of American Italian Pasta from $19 to $58.49 (then trading at $43.65). Bear
Stearns admitted the mistake, and came up with a new valuation, in which Bear Stern™s boosted the estimate
of the company™s operating cash ¬‚ows and dropped its estimate of the cost of capital. Presto! The NPV of this
company was suddenly $68 per share. How fortunate that Bear Stearns™ estimates are so robust to basic errors.
Incidentally, American Italian Pasta traded at $30 in mid-2004, just above $20 by the end of 2004, and at around
$10 by the end of 2005.
¬le=¬nancials.tex: RP
Section 9·3. The Hypothetical Bottom-Up Example ” Short-Term Accruals.

Available Financing ” Executed
Debt Capacity $100
True Lifespan 5 Years
Debt Interest Rate 8%/year
Cost $120, year 1
Raw Output $80/year
Accounting Treatment
’ Input Costs $6/year
Accounting Life 4 Years
’ Selling Expense $8/year
= Net Output $66/year
Overall Cost of Capital 8%/year
Corporate Tax Rate („) 50%

Debt does not require interest payment in Year 1. The world is risk-neutral, because debt and project require the same
expected rate of return (cost of capital).

Q 9.6 For the example in the text, do both the ¬nancials and the cash ¬‚ow analysis using monthly
discounting. Assume that the loan is taken at year start, and most expenses and income occur
pro-rata. (Warning: Time-Intensive Question. Use Excel. Do not do by hand!)

9·3. The Hypothetical Bottom-Up Example ” Short-Term Ac-

You now know how to translate some of the ¬nancials into more NPV-relevant cash ¬‚ows. But Here are other items
that require cash
you can still improve the accuracy of your cash ¬‚ow formula by also adjusting for short-term
(in¬‚ows or out¬‚ows),
accruals. which have not appeared
in this simple example.

9·3.A. Working Capital

To run a business day-to-day requires cash. Firms must put money into cash registers (to The de¬nition of
working capital.
make change), into inventories (to have something to sell), and into extending credit to buyers
(to get them to bite). This is called working capital. Accountants de¬ne working capital as
current assets minus current liabilities. Current Assets are cash, accounts receivables, and
inventories. Current Liabilities are accounts payables, bank overdrafts, tax payables, and
other soon-due bills.

Working Capital = (Current Assets) ’ (Current Liabilities)
= (Cash + Accounts Receivables + Inventories) ’ (Accounts Payables) .

The cash ¬‚ow e¬ects of working capital changes are best explained with an example. Say that Net Income books cash
before it comes in, so
a ¬rm sells $100 of goods on credit. The ¬rm books $100 as net income. But because the $100
accounts receivables
is not yet available, the ¬rm also books $100 into accounts receivables. To compute actual need to be taken out.
cash ¬‚ows, recognize that the cash has not yet materialized: we need to subtract out the $100
accounts receivables from the $100 net income.
This becomes more interesting if you consider multiple years. For example, the ¬rm in Ta- The difference between
cash ¬‚ows and Net
ble 9.8 always sells on credit and is always paid by its customers the following year. An NPV
Income are year-to-year
analysis requires the ¬rm™s actual cash receipts in Line 2, but accountants have provided only changes in working
the information in lines 3 and 4. How do you get back the information in Line 2? Year 1 has capital.
already been discussed: you subtracted accounts receivables from net income to obtain the
actual cash in¬‚ows of $0. Year 2 is more interesting: The ¬rm previously had accounts receiv-
ables of $100, but now has accounts receivables of $300. It is the +$200 change in accounts
receivables (= $300’$100) that needs to be subtracted from the $300 in net income in order to
infer the actual cash receipts of $100. In Year 3, the ¬rm no longer grows and is liquidated, so
the remaining receivables turn into cash that can be recaptured from the business. Again, the
formula to obtain the NPV cash ¬‚ow (Line 2) subtracts the change in working capital (accounts
¬le=¬nancials.tex: LP
216 Chapter 9. Understanding Financial Statements.

Table 9.8. Multi-Year Working Capital

Year 0 1 2 3
1. Sales and Net Income $0 $100 $300 $0
F 2. Actual Cash Receipts (for NPV CF) $0 $0 $100 $300
3. Reported Net Income $0 $100 $300 $0
Ac 4. Reported accounts receivables $0 $100 $300 $0

receivables) of $0 ’ $300 = ’$300 from the $0 net income to conclude that we got +$300 cash
in¬‚ow. Table 9.9 shows these calculations. (Incidentally, recall how you started this subsection
with a Year 1 computation: you subtracted $100 in accounts receivables from the $100 net
income. This worked only because the accounts receivables were the same as the change in
accounts receivables, because the original accounts receivables were zero.)

Table 9.9. Multi-Year Working Capital

Year 0 1 2 3
1. Sales and Net Income $0 $100 $300 $0
F 2. Actual Cash Receipts (for NPV CF) $0 $0 $100 $300
3. Reported Net Income $0 $100 $300 $0
A 4. Reported accounts receivables $0 $100 $300 $0

Your Computations
5. Change in accounts receivables $0 +$100 +$200 “$300
6. Net Income (Line 3) “ Change in accounts receivables (Line 5) $0 $0 +$100 +$300

Line 6 recovers Line 2 from the ¬nancials.

Other short-term accruals that are components of working capital work similarly. For example,
Working Capital already
contains other delayed although corporate income tax is deducted on the income statement for the year in which the
payments, making our
earnings have occurred, ¬rms do not have to immediately pay these taxes. Instead, they can
life easier.
often defer them”at least until (the corporate equivalent of) April 15 of the following year.
To the extent that more taxes can be delayed, more cash is available than is suggested by net
income. Therefore, delayed taxes must be added back to net income when computing ¬nance
cash ¬‚ows. Of course, at some point in the future, these tax payables will have to be paid, and
they will then have to be counted as a cash out¬‚ow of the ¬rm. But, for now, the permitted
delay in payment is like a government loan at zero interest”and one that the accounting item
net income ignores.

Important: The main operation to take care of short-term accruals in the con-
version from net income into cash ¬‚ows is to undo the smoothing”add changes
in working capital.
¬le=¬nancials.tex: RP
Section 9·3. The Hypothetical Bottom-Up Example ” Short-Term Accruals.

Side Note: Alas, as with capital expenditures (see Page 208), the cash ¬‚ow statement has its sign conventions.
The change in cash, accounts receivables, and inventories is recorded as a negative. But accounts payables do
not have the opposite sign from accounts receivables, though they are already an out¬‚ow (negative); they are
left as is. As a result, to compute the ¬rm™s working capital from its line items (accounts receivables, accounts
payables, etc.), you do not subtract current liabilities (e.g., accounts payables) from current assets (e.g., accounts
receivables), but add them together.
Here is an example of the accounting sign conventions. Table 9.4 on Page 203 listed PepsiCo™s changes in
working capital as 84, 416, and 79 for the years 2001, 2000, and 1999:

Cash Flow Statement December
2001 2000 1999
Current Assets
Accounts Receivables +7 “52 “141
Inventories “75 “51 “202
Prepaid Expenses, etc. “6 “35 “209
Current Liabilities
Accounts Payables, etc. “236 +219 +357
Corporate Income Tax, Payable +394 +335 +274
Net Change in Operating working capital +84 +416 +79

Excludes e¬ects of acquisitions and dispositions.

Because these ¬gures come from the cash ¬‚ow statement, to obtain the net change in operating working capital,
all ¬gures are simply added up, not netted out! (The sign of current liabilities has already been reversed for you.)
If you stumble onto the fact that these numbers cannot be inferred from other parts of the ¬nancial statements,
this is because these numbers exclude the e¬ects of acquisitions and dispositions, as well as non-operating
working capital.
Where are changes in cash [in the register] itself? These are not in the changes of working capital, but instead
they are what you ¬nd at the very bottom of the cash ¬‚ow statement.

We can now expand our formulas to include changes in working capital. For example, For- Expand our valuation
formula for another
mula 9.12 transmutes into
source of cash.

NPV Project = EBIT + Depreciation “+” Capital Expenditures
’ Corporate Income Tax ’ Increase in Working Capital .

Anecdote: Working Capital Management
Entrepreneurs usually fail for one of two reasons, and both are common: The ¬rst is that the business is just
not a good idea to begin with. There is not much you can do about this. The second is that the business is too
good of an idea, and the entrepreneur is not equipped to handle the success. The growth in sales consumes
so much cash for increases in working capital that the ¬rm fails to pay back its own loans: The cash is tied
up in production, or in inventory, or in credit extended to customers (payment to be received), when instead
it is needed to ¬‚ow back to the bank. For growing ¬rms, proper working capital management is an issue of
¬rst-order importance.
¬le=¬nancials.tex: LP
218 Chapter 9. Understanding Financial Statements.

9·3.B. Earnings Management

Even though the United States has the tightest accounting regulations of any country, managers
There is considerable
leeway in ¬nancials. still have a lot of discretion when it comes to ¬nancials. There is also no clear line where
accounting judgments become unethical or even criminal. The border zone between ethical
and unethical behavior is a ramp of gray”it may be easy when one is in the clean white zone
or in the clean black zone, but in between, it is often a slippery slope.
We already know that managers must make many judgments when it comes to accrual account-
Not only earnings, but
also cash ¬‚ows can be ing. For example, managers can judge overoptimistically how many products customers will
return, how much debt will not be repaid, how much inventory will spoil, how long equipment
will last, whether a payment is an expense (fully subtracted from earnings) or an investment
(an asset that is depreciated over time), or how much of an expense is “unusual.” However, ma-
nipulation is possible not only for earnings and accruals but also for cash ¬‚ows”though doing
so may be more di¬cult and costly. For example, if a ¬rm designates some of its short-term
securities as “trading instruments,” their sale can then create extra cash”what was not cash
before now counts as cash! Similarly, we already know that ¬rms can reduce inventory, delay
payments to suppliers, and lean on customers to accelerate payment”all of which will gener-
ate immediate cash, but possibly anger suppliers and customers so much that it will hurt the
business in the long run. Firms can also sell o¬ their receivables at a discount which may raise
the immediate cash at hand but reduce the pro¬t the ¬rm will ultimately receive. A particularly
interesting form of cash ¬‚ow management occurs when a ¬rm is lending money aggressively
to its customers. The sales generate immediate cash from sales, and the loans can count as
investments. Of course, if the customers default, all the company has accomplished is to give
away its product for free.
One quick measure of comparing how aggressive or conservative ¬nancials are is to compare
Here is a good warning
sign. the ¬rm to other similar ¬rms on the basis ratio of its short-term accruals divided by its sales. It
is important that “similar” means ¬rms that are not only in the same industry but also growing
at roughly the same rate. The reason is that growing ¬rms usually consume a lot of cash”an
established ¬rm will show higher cash ¬‚ow than a growing ¬rm. If the ¬rm is unusual in having
much higher accruals”especially short-term accruals”than comparable ¬rms, it is a warning
sign that this ¬rm deserves more scrutiny. Managers who decide to manipulate their numbers
to jack up their earnings more than likely will try to manage their accruals aggressively in order
to create higher earnings, too. Of course, this does not mean that all managers who manage
their accruals aggressively do so to deceive the market and will therefore underperform later on.
A manager who is very optimistic about the future may treat accruals aggressively”believing in
few returns, great sales, and a better future all around. Indeed, as noted earlier, the slope from
managerial optimism to illegal earnings manipulation is slippery. Finally, another earnings
warning sign for the wary investor is when a ¬rm changes its ¬scal year”this is sometimes
done in order to make it more di¬cult to compare ¬nancials to the past and to ¬nancials of
other ¬rms in the same industry.
Solve Now!
Q 9.7 A ¬rm reports the following ¬nancials.

Year 0 1 2 3 4 5 6
Reported Sales= Net Income $0 $100 $100 $300 $300 $100 $0
Reported Accounts Receivables $0 $100 $120 $340 $320 $120 $0

Can you describe the ¬rm™s customer payment patterns? Extract the cash ¬‚ows.

Q 9.8 Construct the ¬nancials for a ¬rm that has quarterly sales and net income of $100, $200,
$300, $200, $100, and half of all customers pay immediately, the other half always pay two
quarters after purchase.
¬le=¬nancials.tex: RP
Section 9·4. Completing the Picture: PepsiCo™s Financials.

Q 9.9 (Di¬cult:) Amazonia can pay suppliers after it has sold to customers. Amazonia has 25%
margins and is reporting

Month Jan Feb Mar Apr May
Reported Sales $0 $100 $100 $400 $0
Reported Net Income $0 $25 $25 $100 $0
Reported Accounts Payables $0 $75 $75 $300 $0

What are Amazonia™s actual cash ¬‚ows?

Q 9.10 Are short-term accruals or long-term accruals easier to manipulate?

Q 9.11 Give an example of how a ¬rm can depress the earnings that it reports in order to report
higher earnings later.

Q 9.12 Give an example of how a ¬rm can depress the cash ¬‚ows that it reports in order to
report higher cash ¬‚ows later.

9·4. Completing the Picture: PepsiCo™s Financials

Now, if you take another look at the complete PepsiCo cash ¬‚ow statement in Table 9.4 or Other, so-far neglected
sources of cash hidden in
even the abbreviated cash ¬‚ow statement in Table 9.14 (Page 229), you will see not only the
the ¬nancial statements.
procedures that we have just discussed”starting with net income, adding back depreciation,
subtracting o¬ capital spending, and adding changes in working capital”but a whole range of
other items that we have not yet even mentioned.
There are two pieces of good news here. First, you now understand the main logic of what is Now “wing it.”
going on. Second, you can now rely on the accountants to do most of the hard work for you.
The logic of how to handle the remaining items in the cash ¬‚ow statement is either similar to
what we have already discussed and/or obvious from the name. For instance, you hopefully
won™t need an explanation from me as to why “bottling equity income, net” which appears just
below “net income” and which is added to it is probably just another form of net income”even
if I knew its meaning better than you, it would not help if I explained it to you, because every
company has its own unique collection of named items in their ¬nancial statements. Like I, you
will have to “wing it””or, better, seek to understand the speci¬c company you are analyzing.
There are two other sources and uses of cash ¬‚ow, which we still want to mention, because it Here are a few less
obvious ones.
is not (relatively) obvious from the accounting jargon what is really happening.

Changes in Deferred Taxes arise when ¬rms use di¬erent depreciation schedules on their tax
¬nancials than on their public ¬nancials. Many ¬rms are allowed to use accelerated de-
preciation for tax purposes. The resulting discrepancy in tax timing is then recorded as
“changes in deferred taxes.”
Note that this item has nothing to do with the fact that income tax is paid after it is
incurred (e.g., on April 15). This di¬erence in the timing of taxes incurred and taxes
actually sent to the IRS can be computed as changes in Income Tax Payable, which is itself
a component of changes in Working Capital.

Investment in Goodwill is an item whose name is even more of a misnomer. It has to do
with cash laid out when ¬rms acquire other ¬rms. (It can be a very important item for
¬le=¬nancials.tex: LP
220 Chapter 9. Understanding Financial Statements.

Putting short-term and long-term accruals and other sources/uses of cash together yields a
A semi-complete cash
¬‚ow formula: second and more complete formula for estimating cash ¬‚ows for an NPV analysis from ¬nancial
statements. Cash Flows for NPV analysis can be estimated using a formula like the one in
Table 9.10.

Table 9.10. A Formula To Compute Cash Flows

PepsiCo, 2001

Earnings after Interest before Taxes $4,029

+ add back Interest Expense + ($8)

= Earnings before Interest and Taxes (EBIT) $4,021

“ Corporate Income Tax “ $1,367

= Net Operating Pro¬t $2,654

+ Changes in Deferred Taxes + $162

+ Depreciation + $1,082

= Gross Cash Flow $3,898

“ Increase in Working Capital “ ($84)
(incl. tax payables, etc.)

“ Capital Expenditures “ $1,324

“ Investment in Goodwill
“ All Sorts of Increases in Net Other Assets “ ($211)

= Free Cash Flow from Operations $2,869

+ All Sorts of Non-Operating Cash Flows + ($1,313)

= Total Project Firm Cash Flow (to Debt and Equity) $1,556

+ Net Issuance of Debt + ($341)

“ Interest Expense “ ($8)

= Total Cash Flow to Levered Equity $1,223

In this formula, the numbers on the right are from the abbreviated cash ¬‚ow statement in
Table 9.14. You can also see how similar this is to the accounting cash ¬‚ow statement. It starts
with the net income of $4,029 (from the income statement) and adds back depreciation”unlike
in the income statement, the depreciation on the cash ¬‚ow statement includes all depreciation
of all sorts of assets. The deferred taxes of $162 (i.e., tax depreciation schedule di¬erences)
and non-cash items of $211 are two more opaque items that provided PepsiCo with extra cash
during the year”more than was indicated by its net income of $2,662. The change in working
capital, explained in Section 9·3.A, is cash that PepsiCo had to add to its inventory, loans made
to its retailers, or cash it could recover from its delay of payables and tax payments. In 2001,
PepsiCo actually could reduce and thereby generate $84 in cash from its working capital. In
total, collecting all positive cash ¬‚ow terms, PepsiCo™s business generated $3,898 + $84 + $211
+ $8 = $4,201 million. Of this cash, PepsiCo invested $1, 324 + $1, 313 = $2, 637 million (i.e.,
negative cash ¬‚ows) into things like plant and equipment, advertising and sponsorships, etc.
Another $8 was spent on interest payments. Again, these were actual cash ¬‚ows consumed in
the course of running PepsiCo.
¬le=¬nancials.tex: RP
Section 9·4. Completing the Picture: PepsiCo™s Financials.

Unfortunately, the formula cannot cover all items in all companies”and even for PepsiCo, we It™s a suggestive formula,
not a perfect one.
had to lump some items and ignore others (such as foreign exchange e¬ects). So please do not
consider our cash ¬‚ow formula to be the perfect, end-all formula to compute NPV cash ¬‚ows.
Again, every business operates and reports di¬erently. Still, the formula is a good start for
estimating realized cash ¬‚ows for an NPV analysis for most ¬rms in the real world, and for
understanding the link between earnings and cash ¬‚ows.
Fortunately, most of the time, we do not need to construct the cash ¬‚ow with this long formula An even easier solution
which works better!
ourselves, because we can instead rely on the corporate cash ¬‚ow statement itself. After all,
it tries to construct most of the information for us. Its big items, including even those we
forgot in our long formula, are lumped into the sum of cash ¬‚ows from operating activity
and cash ¬‚ows from investing activity. So we can use this sum instead of ¬ddling with the
components. However, there is one di¬erence between what accountants consider cash ¬‚ows
and what ¬nanciers consider cash ¬‚ows. It is interest payments. Accountants consider interest
payments an operating expense. Financiers consider them a distribution to owners. If we take
care of this detail, we can then rely on our accounting friends:


Project Cash Flows (CF), which pay out to owners collectively (both debt holders
and equity holders in the corporation) are
CFProject = Cash Flow from Operating Activity
+ Cash Flow from Investing Activity (9.18)
+ .
Interest Expense

Net Income, a component of cash ¬‚ow from operating activity, has had inter-
est expense subtracted out. But interest expense is cash that is being returned
to (debt) investors. Thus, to obtain the total amount generated by the project
and available (paid out to) the sum-total of both creditors and shareholders,
the interest expense (from the income statement) must be added back.

Equity Cash Flows (CF), which are available only to levered equity
shareholders”that is, they have subtracted out all in¬‚ows and out¬‚ows to
creditors (debtholders)”are
CFEquity = Cash Flow from Operating Activity
+ Cash Flow from Investing Activity
+ Net Issuance of Debt
= CFProject + Net Issuance of Debt ’ Interest Expense .
¬le=¬nancials.tex: LP
222 Chapter 9. Understanding Financial Statements.

Digging Deeper: Because accountants keep score of both assets and liabilities, the exact same cash ¬‚ows can
also be obtained from the ¬nancing side of the business:

Change in Marketable Securities
+ Decrease in Debt
+ After-Tax Interest Expense
+ Dividends
+ Share Repurchases
“ After-Tax Interest Income
= Total Financial Flow

(Actually, accountants charge after-tax interest as an operating cost, so care must be taken to recognize it as
a distribution.) For complete references, see Corporate Valuation by Bradford Cornell (Irwin), or Valuation by
Copeland, Koller, Murrin (McKinsey).

Will these formulas give us the same result? Let us apply them to PepsiCo. Adding total oper-
PepsiCo™s cash ¬‚ow, the
easy way. ating activity of +$4, 201 and total investing activity of ’$2, 637 gives $1,564 in operating
activity net of investing activity. Finally, we need to add back any interest expense that was
taken out from net income. (After all, the project generated these funds and they were paid out,
just as dividends are paid out.) In PepsiCo™s case, it is not an interest expense, but net interest
income, so the cash ¬‚ow that we would use in an NPV analysis of the business of PepsiCo for
2001 is
CFProject = Cash Flow from Operating Activity

+ Cash Flow from Investing Activity
+ Interest Expense (from the income statement)

= $4, 201 + (’$2, 637) + (’$8) = $1, 556 .

(PepsiCo is the rare company that did not pay interest income, but earned interest income in
2001!) These are the cash ¬‚ows accruing to all owners together, debt and equity. We are still
interested in the cash ¬‚ow that is earned by PepsiCo™s levered equity (without the creditors).
We need to add cash obtained from net issuance of debt (the di¬erence of debt principal that
we raised and debt principal that we repaid, which we can read from the cash ¬‚ow statement),
and we need to subtract interest that we paid.

CFEquity = CFProject + Net Issuance of Debt ’ Interest Expense
= $1, 556 + ’ = $1, 223 .
(’$341) (’$8)

Both numbers are identical to those on Page 220. It must be noted that you might some-
times need the longer formula with its individual components, because they may need to be
discounted by di¬erent interest rates. We will see more of this later.
PepsiCo showed an increase in net income from 1999 to 2001. Did it also have an increase in
See how much earnings
and cash ¬‚ows can differ. cash ¬‚ows? The answer is no. In 1999, PepsiCo had NPV cash ¬‚ows of $3, 605’$1, 172’$792 =
$1, 641; in 2000, it had cash ¬‚ows of $4, 440 ’ $1, 996 + $57 = $2, 501; in 2001, it had NPV
cash ¬‚ows of $4, 201 ’ $2, 637 ’ $8 = $1, 556. Yet, even in 2000, managers used changes in
working capital to prevent PepsiCo™s cash ¬‚ows from dropping even further. It may be that
PepsiCo did not show stellar three year improvement, after all. On the other hand, the cash
was not discarded but used. Naturally, judging whether these were pro¬table investment uses
is a di¬cult matter.
The cash ¬‚ow statement in Table 9.14 also continues where we stopped. It proceeds to tell
us what PepsiCo did with its projects™ (post interest) cash ¬‚ows: It used $994 million to pay
dividends, $579 million to repurchase its own equity shares, and $341 million to repurchase
its own debt, for total capital market activities of $1,919 million. In fact, this means it paid out
more than it made in 2001 to the tune of $1, 919 ’ ($1, 556 + $8) = $355 million. (Presumably,
¬le=¬nancials.tex: RP
Section 9·4. Completing the Picture: PepsiCo™s Financials.

PepsiCo still had cash lying around. Of course, this cash, too, was not generated in 1999, as
PepsiCo also bled cash in 2000. It was in 1999 that PepsiCo produced the cash it consumed in
2000 and 2001.)
Our task is done”you can now look at a ¬nancial statement and obtain an estimate of the The task is done!
information they contain about cash ¬‚ows that matter to your NPV analysis.
Solve Now!
Q 9.13 From memory, can you recall the main components of cash ¬‚ow used in an NPV analysis?
Do you understand the logic?

Q 9.14 Is the ¬rm™s lifetime sum of net income (about) equal to the ¬rm™s lifetime sum of cash

Q 9.15 A new ¬rm reports the following ¬nancials:

Income Statement December
2001 2000 1999
= Revenue 200 162 150
COGS 60 58 57
+ SG&A 20 19 18
Operating Income
= 120 85 75
- Net Interest Income (Gains&Losses) 35 35 35
Income Before Tax
= 85 50 40
“ Corporate Income Tax at 40% 34 20 16
Income After Tax
= 51 39 24
“ Extraordinary Items 0 0 0
Net Income
= 51 39 24

The ¬rm also reports

Source Item 2001 2000 1999
Cash Flow Statement Capital Expenditures 0 30 200
Cash Flow Statement Depreciation 25 23 20
Balance Sheet Deferred Taxes 20 16 0
Balance Sheet Accumulated Depreciation 68 43 20
Balance Sheet Working Capital 35 25 20


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